PROFIT MARGINS: THE SQUEEZE IS UNDERWAY

The Q1 2017 earnings season is over and the surprising 14% gain in S&P 500 company earnings is prompting many to declare that we’re off to the races again. Corporate America’s magic is impressive and seems unabating. But a closer look reveals a very different reality.

The Commerce Department released national corporate profits data last week and the WSJ found one explanation for the recent earnings surprises (my emphasis):

(…) The Commerce Department said that what it calls rest-of-the-world profits rose 25% in the first quarter from a year earlier. These profits are based on the receipts companies are getting from abroad—for exports, for example— less the payments they send to other countries.

This number matters because it shows just how strong U.S. companies’ overseas earnings are. And it breaks down the source of earnings in a way that doesn’t show up in the S&P 500 figures. Because it doesn’t count all the profits from U.S. companies’ overseas units, the government numbers understate overseas earnings, which is one reason why overall S&P figures look stronger.

For investors there is bad news and good news here.

The bad news is that domestic U.S. profit growth is slowing. Take away the rest-of-the-world profits, and the Commerce Department figures show domestic after-tax profits were down slightly from a year ago, and well off their 2014 peak. That’s a reflection of how rising costs for labor in combination with a slow-growing U.S. economy are grinding down profit margins.

The good news is that companies’ overseas operations have taken the baton, and ought to be able to keep running with it for a while. Economic growth in places like Europe is stronger and emerging markets are looking a lot steadier lately. (…)

One problem with the above is that 70% of S&P 500 companies revenue is domestic and domestic nonfinancial profits peaked in 2014 and have since declined 11% with no signs of a turnaround just yet.

One of the main reasons: lower oil prices. Industry breakdown is not yet available for Q1’17 but between 2014 and 2016, 74% of the $94 billion decline in U.S. domestic nonfinancial profits was from the “Petroleum and coal” industries, further underscoring the importance of oil on total U.S. corporate profits and margins (see “This Time Seems Very, Very Different.” Really?). Given continued low oil prices, the oil industry will need to cut costs significantly to restore previous profitability.

In effect, Energy profits (red line in the CPMS/Morningstar chart below) peaked with oil prices (black, lagged 9 months) in 2008, peaked again in 2012 until collapsing in 2015-16.

Annual earnings of S&P 500 Energy companies peaked at $51 in 2008 and again at $44.31 in 2012. The industry lost $13.71 in 2015, $3.49 in 2016 and is set to earn $17.00 in 2017 per the current consensus estimate based on an increasingly suspect $60 oil price assumption. Energy earnings are thus unlikely to provide much impetus to the total for some time.

But how did total profits hold given the collapse in Energy earnings since 2012? Indeed, S&P 500 EPS rose 9.8% between 2012 and 2016.

Four sectors displayed well above average growth (Cons. Disc., Health Care, IT and Real Estate, currently 52% of the S&P 500 Index). The work horses were the six MAGNAFicient companies (MSFT, AMZN, GOOG, NFLX, AAPL, FB) which are part of the CD and IT sectors (see THE SIX-HORSE HITCH):

The fast growing sectors account for 52% of the Index while the negative growers are but 11%. The strongest horses are the healthiest.

But even strong, healthy horses eventually slow down.

Another, and more significant reason for the flattening of domestic nonfinancial profits is that labor costs have begun to rise faster than revenues as this chart demonstrates:

The ensuing squeeze in corporate operating margins is clearly underway and very unlikely to stop given the obvious tightening in the U.S. labor market. It has been a while, but we have seen this movie before.

Back to the Q1 surprise 14% jump: it’s nice to know that foreign profits saved the quarter, but is the WSJ’s assertion that “foreign operations have taken the baton and ought to be able to keep running with it for a while” supported by facts.

After all, even though Euro-area GDP growth outpaced America’s in Q1’17, it is still quite weak at +2.0% annualized. Canada’s GDP growth rate remains below 2.0% and so is Japan’s at 1.3%. China and Mexico are also unlikely to accelerate on their own.

In truth, there were unsustainable contributors to foreign profits in the first quarter:

U.S. exports jumped 6.2% YoY in Q1, from +2.4% in Q4’16, but that was on a very depressed early 2016 base (Q1’16 exports were down 4.8% YoY). Export growth has actually stalled sequentially during Q1, the 0.9% MoM drop in March erasing all the Jan.-Feb. gains.

More importantly, foreign profits seem to be largely influenced by fluctuations in commodity prices and currencies, both inherently too unpredictable for anybody to assert that anything correlated with them will “keep running for a while”. Foreign earnings tripled between 2002 and 2008 as commodity prices exploded and the U.S. dollar declined 25%. They have been going sideways since, fluctuating between $350 and $450 billion along with commodity prices.

RBC Capital tracks the results of the 200 Globally Oriented companies in the S&P 500 Index. These companies recorded revenue growth of 3.3% in Q4’16 with 55% of them surprising on the upside but by only 0.1% on average. The same companies registered revenue growth of 8.9% in Q1’17 on a 75% beat rate and a 0.6% surprise factor. Foreign economies did not grow so much faster to explain such acceleration.

Profits of the same companies rose 5.3% in Q4’16 but exploded 15.2% in Q1, with an 81% beat rate and a huge +6.2% surprise factor. I doubt that companies have suddenly become lousy budgeters. In reality, they were surprised by the jump in commodity prices post the U.S. elections.

In all, it is doubtful that the Q1 surprise in total profits will extend through the rest of 2017. First, foreign profits will not repeat their Q1 surprise jump all year. Two, domestic profits have already started to feel the labor cost squeeze and relief is unlikely over the foreseeable future. Given that 70% of S&P 500 revenues are domestic, this latter trend will predominate.

As further evidence, this chart from Ed Yardeni illustrates the deterioration in margins of smaller American companies since 2014. Small companies are more domestically focused and generally have a bigger labor component than larger companies. Furthermore, the S&P 600 Index has 35% of its capitalization in Industrials and Consumer Discretionary companies, far more than the S&P 500 (23%) and the S&P 400 (26%). Smaller companies saw their margins peak well before large firms in the mid-2000’s.

Going even deeper into the world of small companies, the National Federation of Independent Business (some 75% of NFIB members have fewer than 14 employees) publishes this chart where I have identified the last 3 periods when labor costs were rising faster than selling prices, compressing profit margins. These trends correlate very well with the earlier chart plotting compensation of employees as a percent of corporate revenues. Keep in mind that small companies employ the bulk of American workers.

So, this time is clearly not different after all (“This Time Seems Very, Very Different.” Really?). Perhaps central banks’ highly unusual policies are making things happen slowly. Also, the percentage of American workers represented by labor unions has steadily declined from 23% in 1983 to 16.7% in 1995, 13.8% in 2004 and 12.3% in 2014, potentially slowing down the compensation adjustment process. Yet, labor also operates within communicating vessels and there is increasing evidence that the squeeze is moving up the corporate size scale.

One, the economy-wide private quit rate really accelerated starting in 2014 and is now at its 2004 level. People generally voluntarily change jobs only if their conditions get meaningfully improved.

Secondly and most importantly, recent surveys of large corporations indicate that the wage pressures are really intensifying:

The Fed’s surveys of businesses included in its Beige Book started to mention “wage increase” more often in late 2014 and the last survey had as many mentions as at the last peak in 2007 (chart from David Rosenberg)

Markit’s recent PMI surveys are increasingly alarming on the tightness of the labor market and rising compensation costs. From May’s Flash U.S. PMI survey:

Measured overall, average cost burdens increased at a robust pace during May. This was driven by the steepest rise in service sector input prices [mainly wages] since June 2015. (…) The latest survey also pointed to greater cost pressures across the service economy, which firms linked to rising staff salaries and higher raw material costs (particularly food). Sustained pressure on margins led to the most marked increase in average prices charged by service sector companies since December 2016.

Absent a stronger demand environment, squeezed companies will try to protect margins by raising selling prices, inflating costs across the board until the Fed stops the music. In the event that the economy accelerates and inflates revenues, labor costs will only accelerate even more given the already tight environment.

Previous ways out are not obvious as Chinese wages are also rising rapidly and Mr. Trump tweets out just about every new offshoring attempts.

That’s what a lobster trap must feel like. Classic end-of-cycle scenario. They generally never end smoothly and on their own, although profit recessions have happened before.

The headwinds on equities are getting stronger:

Oil prices remain low.

Employee compensation is rising faster than revenues.

The overall economy seems stuck around 2% growth.

The Fed is tightening.

Trump hopes are fading.

Equity bulls don’t know it but their feedstock is gradually losing its main nutriments of rising earnings and low interest rates.

Equity bears also don’t know it being blindsided by recent earnings surprises. Those who have staying power are likely to get the honey pot fairly soon.

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